European stock market outlook 2023: all states are equal, but...

Investors will need to be conscious that, far from being a union, the EU is likely to become increasingly a two-tier bloc, says our overseas investing expert Rodney Hobson.

Mario Draghi was always going to be a tough act to follow as president of the European Central Bank (ECB). It is a lumbering giant that needs to pull together the competing needs of 19 widely differing eurozone countries at varying stages of economic progress and stability.

Draghi, short of ammunition he could use quickly, talked the talk and carried the world with him. He was replaced in 2019 by Christine Lagarde (pictured above), who ran straight into the strains of the pandemic shutdowns and the accompanying threat to heavily indebted countries such as Italy, where Draghi had jumped out of the frying pan and into the fire of leading the government.

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Life could at last be turning easier for Lagarde. Inflation in the zone rose relentlessly throughout most of 2022, driven by rising food and fuel prices and weakness of the euro against the US dollar. Average annual consumer price inflation hit 10.6% in October. 

Economic forecasters were taken by surprise when that figure slipped to 10% in November, the first drop since early in 2021. The three countries faring best were Spain, the Netherlands and Germany. Since the last of these three is the powerhouse of Europe and the one that has been most dependent on Russian gas, the news has been greeted with some relief.

Hopes have naturally risen that eurozone interest rates will not rise as strongly or as far as previously feared after two increases of 0.75%, the biggest so far by the ECB, to take the rate to 2%. However, the current inflation level is higher than the bank forecast as recently as September and it is five times the bank’s 2% target.

The three Baltic states of Estonia, Latvia and Lithuania all have inflation rates above 20%, once again raising concerns about whether the eurozone has expanded too far to be manageable.

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It does seem likely that inflation in Europe has passed its peak, although economists think it will take until March or April before it falls back significantly. The slippage in the value of the dollar, in which oil and gas are priced, will help, but the eurozone, like all areas of the world, is at the whim of global demand and prices.

However, economic forecasting is a mug’s game in which experts find themselves reacting to changing circumstances and forever playing catch-up rather than gazing into an accurate crystal ball. Lagarde herself learnt that only too well when she was managing director of the International Monetary Fund (IMF).

Lagarde will certainly be hoping that the latest growth forecasts issued by the European Commission in November are unnecessarily pessimistic, saying as they do that recession is likely to persist well into next year. Germany, the largest European economy, is set to suffer most, with gross domestic product shrinking 0.6% in 2023.

The prognosis is that recession will be spread broadly across the 27-nation bloc, with only Ireland seen as growing, by 3.2% according to the commission. The eurozone lost momentum in the third quarter and “the outlook for next year has weakened significantly”.

Despite ever closer union within Europe, serious differences remain, as demonstrated by the suspension during the pandemic of rules restricting state aid for ailing companies. France and Germany were, and remain, the two countries most in favour of allowing state aid and for good reason: their governments can afford to dish out the cash.

Other nations with larger national debts have found themselves less able to replicate such generosity, leaving companies in Southern Europe and in the Baltic at a considerable disadvantage. Paris and Berlin want state aid to continue.

To add fuel to the fire, Germany has been pumping hundreds of billions of euros into reducing energy bills, while resisting calls for increased EU borrowing to shore up less wealthy members. Investors will more than ever need to be conscious that, far from being a union, the EU is likely to become increasingly a two-tier bloc where the haves have more and the have-nots less: success will be clearly easier for companies based in richer countries.

Inflation in the eurozone, even if it has peaked, has been more worrying than in the US, topping 10% just as America was turning the corner. Even Germany reached 11.6%.

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Another challenge for Europe is its shrinking workforce as an ageing population outnumbers a birth rate falling in most countries below the death rate. Despite a counterbalancing from the flood of mainly young refugees from trouble spots to the south and east, Germany and France are just about maintaining a stable workforce, while Italy is falling back sufficiently to be a cause for concern.

Then there is the debt to GDP ratio that indicates how well each economy can handle its national debt. While Germany’s ratio is below 100%, that of France is 113% and rising, while Italy’s is a worrying and potentially unsustainable 150%.

Investors to Europe will naturally be drawn towards Germany, which, despite its frantic race to wean itself off Russian gas, remains the strongest economy on the Continent. However, the best prospects could just be in France, Europe’s second-largest economy.

France has rebounded well from Covid-19, with the economy recovering 6.8% last year and well above 2% this year. A 0.2% improvement in the second quarter and 0.5% in the third beat expectations. This pace may not continue but even so experts expect the French economy to expand modestly, perhaps by 0.5%, which could well be better than those of its immediate neighbours. Tourism in particular could hold up better than in the Covid-affected past three years as cross-border travel continues to pick up, despite the pressures on wage levels in Europe and elsewhere.

Inflation is also forecast to be less of a problem in France than in other eurozone countries, thanks to lower energy prices resulting from a higher output from nuclear power stations and government caps on electricity and gas prices.

For European countries, the words of the old music hall are likely to be true in 2023: there’s nothing surer, the rich get richer and the poor get poorer. Investors bearing that in mind should end the year completing the chorus: in the meantime, in between time, ain’t we got fun.

Rodney Hobson is a freelance contributor and not a direct employee of interactive investor.